Fiscal Austerity Requires Monetary Liberality

Over at Cafe Hayek, Russ Roberts takes on Paul Krugman’s claim that most studies show fiscal policy tightening will stall a recovery rather than help it:

Unfortunately, Krugman doesn’t provide a link to those “many studies” of the historical record. Maybe he was busy or simply didn’t have room to provide them. But I will just mention that in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived. That’s a great natural experiment. I am eager to read any of the alleged many studies of the historical record.

Like Roberts, I am skeptical about the ability of discretionary fiscal policy to stabilize the business cycle. His critique, however, is too quick to embrace the popular view that fiscal policy consolidation actually improves the economy. On this point, Krugman is correct that most of the empirical evidence (e.g. here, here, and here) does not support this view. What the evidence does show is that in most cases where fiscal consolidation was accompanied by a robust recovery it happened because monetary policy was accommodative. In other words, a loosening of monetary policy made it appear that fiscal policy tightening was the cause of the economic recovery when in fact it was not. For example, the much celebrated case of Canada’s fiscal retrenchment in the later half of the 1990s coincided with the Bank of Canada dropping interest rates about 5% which supported domestic demand and increased exports via currency depreciation. For fiscal austerity to work then, monetary policy needs to be accommodating.

Along these lines, a more general point is that the impact of any fiscal policy action–where expansionary or contractionary–depends on the stance of monetary policy. Thus, from 2008-2009 when monetary policy was effectivelytight the easing of fiscal policy didn’t quite pack much of a punch. Conversely, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery. Another way of saying this is that an independent monetary policy will always dominate fiscal policy.

So if Russ Roberts is like me and wants fiscal policy consolidations that works he should really be clamoring for more monetary stimulus. Otherwise he may get more than he bargained for.